Financial Management 244
Behavioral Finance
Introduction
We start by looking at the share prices of 2 well-known cellphone companies: Vodacom and MTN.
From the graphs shown in the slides, we can see that the share price of Vodacom is higher than that
of MTN. Using the share price as an indication of the true performance of these companies can only
be done if the JSE is an efficient market.
In chapter 9, it was stated that a stock market, such as the JSE, is said to be efficient if at any point in
time, the price of a company’s share:
Fully reflects all available information about the company in question. There are 3 forms of
market efficiency:
o Weak form: this implies that a share price reflects all historic information about a
company, such as share price movements, dividend payments and trading volume.
This information is available to all investors.
o Semi-strong form: this encapsulates the weak form and implies that companies
reflect public information. This includes information reflected in the company’s most
integrated report, on their website and/or announced in their stock exchange news
service (SENS). This public information is available to all investors. The JSE falls under
this category.
o Strong form: This rarely happens. This implies that prices also reflect private/inside
information. It includes details of an upcoming merger, or special dividends that
have not yet been announced – only insiders have access to this information.
Rapidly adjusts to new information
Is in equilibrium
Insider trading is considered illegal because it gives the insider an unfair advantage in the market
and allows him/her to artificially influence the value of a company. Insider trading is not only illegal,
but also unethical. There is quite a broad definition attached to who is considered to be an insider. In
essence, it is anybody who has private information that could influence the share price of a
company.
By definition, and insider is a person (a director, employee, adviser or even a journalist) who is made
aware of a proposed transaction that could affect the price or value of a listed security. The potential
pool of people who could become insiders is large and could even extend to advertising and
production companies employed to compile and produce confidential information (such as
newspaper adverts and other price-sensitive notices). Those people involved in defining interest rate
policies are also insiders in relation to government debt instruments.
The second characteristic of an efficient market, whether it is weak, semi-strong or strong form, is
that the share prices react quickly to new information. In this era of computer-generated trading, it
could be within seconds of new information being made available. “New information” is generally
something that the market did not know before and could affect the value of the company. It is
important to note that good news does not always leave to a share price increase. Market
participants evaluate the news relative to their expectations. If the news exceeds their expectations,
prices will generally increase. If the announcement falls short of the market’s expectation, it is
considered bad news, and in such a case, a fall in the price of shares is seen. If an announcement is
in line with the market’s expectation, the share price generally does not react. Security prices cannot
, be predicted, and they follow a random, unpredictable path/pattern in the short-term. Generally
speaking, the value of a share does increase in the long run.
The final characteristic of an efficient market is that share prices are in equilibrium. This means that
the expected return equals the required return (CAPM – Capital Asset Pricing Model). The intrinsic
value will also equal the market value. Also note that active investors cannot out-perform passive
investors after transaction costs have been taken into consideration. An active investor is somebody
who creates their own portfolio based on selected trading rules and/or investment criteria. A passive
investor is one who invests in tradable market indices. This market index is set to reflect the
performance of a particular market. Passive investors who wish to track the market in South Africa
typically create portfolios consisting of the top 40 companies based in market capitalization.
Although markets are efficient most of the time, some anomalies have been observed. This includes
active investors out-performing passive investors. Academics have turned to the field of behavioral
finance to explain these anomalies. One of the basic assumptions/premises of behavioral finance is
that investors do NOT always act rationally. A rational decision is one that is based on or made in
accordance with logic or reason. Rationality can help us to solve problems and draw conclusions.
Greek philosophers and mathematicians were the first to introduce the notion of logic and reason in
the Western world.
Irrational Behavior
An irrational decision is one that disregards logic and reason. It can be made due to emotional
distress (e.g. when people panic) or due to cognitive deficiency. A lot of academic research has been
undertaken to determine why people exhibit irrational behavior, especially in the fields of economics
and finance. Pioneers of this research include Daniel Kahneman, Leon Festinger, Amos Tversky and
Robert Shiller.
Whereas traditional financial theory suggests how individuals should make (rational) decisions,
behavioral finance theory describes how they actually make decisions. These are sometimes
irrational and influenced by emotions. Concepts that will be closely studied in this module include
herding, which is the irrational behavior that can occur when investors and financial managers
blindly follow others when making decisions.
Herding
This occurs when individuals follow others blindly when making decisions. This is sometimes also
referred to as the bandwagon effect. This stems from the idea of everybody climbing onto a
bandwagon and doing what others are doing. A practical real-life example is that of fashion. People
follow fashion trends mindlessly, whether it is flattering or practical. People follow fashion trends
because they want to feel like they belong to a community. It is the social pressure to conform, and
therefore we mirror the decisions of those around us. People validate their decisions by claiming
that it cannot be wrong if everybody else is making the same decision, but we know that this is not
always true.
In terms of investment, it is when one invests in or divests from companies, industries or countries
based on what others are doing without fundamental or technical analysis.
The issue with herding is that the herd/audience is not always right. In an investment perspective,
we have seen that herding behavior/chasing the market has resulted in the formation and bursting
of a number of investment bubbles. An example would be real estate in the States in 2007.
